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the argument for micro foundations in macroeconomics seems to me much weaker then the argument for macro foundations in microeconomics. Also, your emergent properties argument sounds reasonable, but i don't think it really is. it is entirely reasonable that predator prey models don't model cellular or molecular interactions. This isn't to say there is no place for understanding individual and firm behavior in macroeconomics, only that it should be acceptable not to in certain instances.

I definitely agree with your second point and said something similar this morning in linking to Noah's post. He listed two goals of macro: forecasting and policy analysis. Both are important, and the second even holds some interest for me. But the most important reason why I'm interested in macroeconomics is simply to understand how the macroeconomy works: not to predict or manipulate, but to explain.

Obviously manipulation comes in handy given current macroeconomic hardships - I wouldn't deny that. Prediction I think is fool's errand outside of the very near term in a complex system. But explanation is a real goal worth pursuing.

I agree with Nathan too on macrofoundations of microeconomics. I think a lot of microeconomic discussions of things like unemployment and the minimum wage are weakened because they're discussed only in a microeconomic, partial equilibrium framework. There is no good reason to think that theoretical consistency must run in only one direction.

Nathan: "it is entirely reasonable that predator prey models don't model cellular or molecular interactions."

Yep. But sometimes there are (or at least, seem to me to be) "natural breaks" in levels of explanation. It seems OK to me that macroeconomic models might treat households, firms, and governments as "black boxes", and leave microeconomists to explore the inner workings of those entities.

Daniel: Yep. From your blog this morning: "However, there's a third thing that we want to get out of economic models that is actually the most important reason for me: explaining the economy. Not predicting its future path. Not advising policymakers. But simply understanding how it works. And for that, I think both non-structural and structural models are useful. Since explanation is preferably causal rather than just descriptive, we don't want to ignore the microfoundations."

We are on the same page here. Funny how we want to say that we do things only because they are useful, when we sometimes do them for their own sake.

I never understood the basis for what macroeconomists call "microfoundations." I mean, I understood their desire to get around the Lucas Critique. I just never managed to understood why anyone thought the modern approach would work.

Certainly my microeconmics profs were at pains to point out why it was stupid. Proper microfoundations, they said, did not rely on assumptions about functional forms (like Cobb-Douglass, or CRRA, or even time-separable utility.) Those assumptions were not structural, and so should not be assumed to be "deep". Then came the aggregation theorems. Aggregation is possible only under very strict and unrealistic conditions, they said. Otherwise, shocks to the distribution of income, or resources, cause shifts in the aggregate demand or supply equation. The postulate of a representative consumer, or firm, they said, was literally incredible.

None of that has stopped modern macro from writing down Cobb-Douglas production functions for representative firms, assuming a single consumption good and a representative consumer with CRRA utility (if not just logarithmic) and then "proving" results. But it seems to have a lost any concept of how fragile those results are to very ad hoc (and often logically inconsistent) assumptions. I think it has also tended to ncrease the gulf between modern macro and microeconomics.

Here's another thing that I think's been missed: if we have some purely empirical/descriptive "model" with no microstructure, it will inevitably fail as soon as the state variables are outside the domain that it was fitted on. The only hope for extrapolating to other regimes is if the model correctly captures some deeper relationships including their boundary conditions and asymptotic behaviours.

Here's another thing: anybody who's ever tried to fit the "best" model to some arbitrary data will know that unless the model is linear with a small number of variables, the possible non-linear terms that could plausibly be added are essentially limitless. Without microfoundations, the task of choosing the the right form of model to fit is hopeless: there are inevitably vastly more possible terms than data points to fit, and the whole endeavor is pretty pointless.

The laws of thermodynamics, or electromagnetism weren't discovered by throwing random regression models at experimental data either. There's just not a lot of hope for trying to get away with not having to actually think about what we're doing.

You making the case for micro foundations ... or _math_ foundations.

They are not the same thing.

For example, there are micro arguments against the picture contained in math constructs of both perfect compeition and monopolistic competition.

Yep they are pretty random.

These may be nice arguments for studying microfoundations. But they are not arguments for using microfoundations (for forecasting or policy analysis.) Most definitely, they are not arguments for their dominance, nor for their requirement in building macro models (as some want). I don't think there is any serious (not talking about Serious) economist who is against studying microfoundations, so I am not sure what point you want to make with these two points.

Greg: "You making the case for micro foundations ... or _math_ foundations.
They are not the same thing."

Agreed. They are (almost?) orthogonal. Some Old Keynesian macromodels had loads of math but no microfoundations. And you can tell the (e.g.) Lucasian story of the Phillips Curve using words, even though it was also done with math. I am (I want to be) making the argument for microfoundations, not math. Which brings me to Simon's comment:

I see a big difference between making assumptions about (e.g.) functional forms for math tractability and doing microfoundations. I want a story. It doesn't have to be told in math. Stories always leave out a lot of detail. If the storyteller thinks that agent heterogeneity doesn't matter for the plot, then leave it out. Even the Old Keynesian models with no microfoundations had lots of aggregation and linear functional forms etc.

Christiaan:

I actually don't understand how *any* (microfounded or not) models can help us with macro forecasting. See my old post here.

There are other arguments for wanting microfoundations for policy advice. Not just the Lucas Critique, but the argument that if policy is supposed to be about people's well-being, it might be a good idea to have some people in the model, so we can see what happens to their well-being when policy changes.

This post is not about whether non-microfounded models are bad, or useless. Even if every other economist agreed with me that studying microfoundations is good, I would still want to write this post. "Here are two reasons (ones you may have missed) why studying microfoundations is good". Not every post has to be a polemic against people who think the opposite. A post can still have a point even if it's not a fight against someone else.

Christiaan: let me put it another way. Does this post lead to any earth-shatteringly important and controversial changes in how we should do macro? Nope. That's why I said "I just wanted to add my twopence-worth.", and kept the post very short, so it still comes out relatively OK, IMHO, on the "value per word" measure.

With respect, Nick, it seems to me that both your reasons are begging the question, because both require that micro-founded models "work", in the sense of producing in a non-trivial way emergent properties that match those empirically observed and not producing any that don't. A model that is wrong doesn't offer any inferential support for its premises, nor does it offer any insight into how macroeconomics works.

But in so far as there is a point being debated in the micro-founded blog wars, it is this: the proposition that the current generation of DSGE models are either unfalsifiable - i.e., make no interesting predictions, or possess emergent properties that are the result of "non-structural" assumptions (i.e. are not really emergent), or are all too easily falsified - make interesting predictions that are observed to be wrong.

Can we understand how emergent properties emerge?

It's interesting that this whole discussion is coming up again, including the cellular automata type arguments. I remember mentioning this back in the day, but maybe it wasn't the right time. Here's the thing: from the initial state of a cellular automaton---no matter how simple---there is no general way to deduce with any degree of accuracy how much later states are going to look without actually running the automaton. Even slight differences in the initial state potentially (and probably) lead to wildly different outcomes, with, again, no way to predict how it happens.

So no, under the current boundaries of mathematics, you can't really understand how emergent properties emerge.

But, of course, it appears to be the case that even macroeconomics depends on assumptions about individuals writ large. So the lack of what people are calling "microfoundations" are a big problem. However, since microfoundations are basically impossible---it's trying to deduce the aggregate behaviour of a system from an initial state of a sort of cellular automaton---it is a big problem for the concept of "economics" as a whole.

Phil: Do macro models with monopolistic competition "work". Well, I would say they "work better" than similar models with perfect competition. The micro inference is not one of logical entailment (almost nothing in economics is), but I think it does provide *some* weight of evidence, and *some* insight.

E.g. my post a week or so back. Does PPP "work"? Of course not, if by "work" you mean "always gets exactly the right answer". But it works a helluva lot better than nothing, and does give some insight into exchange rates.

Mandos: 1. "Even slight differences in the initial state potentially (and probably) lead to wildly different outcomes, with, again, no way to predict how it happens."

Is that the same as:

2. "So no, under the current boundaries of mathematics, you can't really understand how emergent properties emerge." ?

Suppose 1 is true, and I can fully believe it is true under some conditions. I want to understand why 1 is true under some conditions, and what those conditions are, and whether or not those conditions apply to macroeconomics, and where. And if that leads to some sort of indeterminancy at the macro level, so be it, and I want to understand that too, and whether and how it limits our ability to "understand" macroeconomics with models that are not microfounded.

@Nathan (first comment):

I'm a population ecologist. No, no population ecologist would model the internal molecular workings of predators and prey. But we certainly do try to build up an understanding of predator-prey population dynamics from considerations of the properties of predator and prey individuals (e.g., their behavior, body size, etc.) And when those properties are heterogeneous (e.g., some predators are bigger than others, different prey behave differently, etc.), the challenge of scaling up from the 'microscale' properties of individuals to the 'macroscale' properties of collections of individuals (populations) becomes both very interesting and very challenging.

Of course, there are ecologists who argue that 'macroecology' has a 'life of its own', independent of any 'microfoundations', or that the search for 'microfoundations' of 'macroecology' is fruitless. That's not a point of view I personally share. Here's a bit of discussion of this topic in an ecological context, which I think is sufficiently non-technical that non-ecologists will find it accessible:

link here NR

link here NR

And as long as I'm shamelessly self-promoting ;-), here are two more (which may be somewhat less accessible to non-ecologists; I'm not sure):

link here NR

link here NR

@ Jeremy Fox. Thank you very much for the links. I totally understand your point about environmental and body type considerations as being very important to predator prey models. However, if anything, i think that's a better argument for qualitative research methods in economics then micro-foundations in the sense that economists talk about them (something which is completely illegitimate in mainstream economics). In addition, would you not agree that not all models should have to explicitly consider those type of micro-foundations to be publishable? that is the condition i perceive in (mainstream) economics.

@ Jeremy fox. are you familiar with the work of richard goodwin? i would love to talk to you about predator prey models (and other ecology models) and their application to economics.

Jeremy: thanks for those very relevant links. It's fun reading them substituting "macroeconomist" for "macroecologist" etc.

Nathan:

Don't know that I agree that "you should have to explicitly consider micro-foundations for your model to be publishable." That sounds like a pretty strict stance, even for someone who (like me) thinks it's a good thing to understand how to scale from 'micro' to 'macro'. Certainly, that strict stance isn't actually the case in ecology. Plenty of people publish macroecological work (much of which is empirical rather than theoretical, by the way) without explicitly discussing micro-foundations.

No, I don't know Richard Goodwin's work. A quick glance at his Wikipedia page looks intriguing, I'd be curious to learn more. I have no idea if the application of, say, Lotka-Volterra predator-prey models to economics makes any sense, but I'm intrigued that anyone would even think of the possibility. More broadly, anyone who's thinking about economic cycles as having endogenous causes, as Goodwin seems to, sounds like they're on the right track to an ecologist like me. As an ecologist who doesn't know much about economics, I've always found the emphasis that many economists place on exogenous 'shocks' to be a little odd, and wondered if I'm just misunderstanding what economists think about where business cycles come from.

Indeed, for an ecologist, lots of discussion of macroeconomic models is like looking at ecology in a funhouse mirror--it's a recognizable but altered mirror-image. Just to pick one random example, using isocline plots to think about the response of a dynamical system to an exogenous shock that temporarily shifts the isoclines, is something that macroeconomists seem to do routinely. But it isn't something that would ever occur to a population ecologist to try to do; that's just not among the purposes for which we ordinarily use isocline plots.

@Jeremy, unfortunately i think you get it much more then you think you do. Mainstream economics has a tendency to look for exogenous causes when explaining suboptimal outcomes. I completely agree that instability resulting from endogenous processes is a much more interesting endavor for me personally. Hyman Minsky, although he didn't provide a dynamic mathematical model, has a lot of interesting insights that I'd like to put into Mathematics. Steve Keen, who is somewhat polemical (and has gotten a lot of negative reaction very recently) is working on doing precisely this in his positive research program.

Jeremy: "As an ecologist who doesn't know much about economics, I've always found the emphasis that many economists place on exogenous 'shocks' to be a little odd, and wondered if I'm just misunderstanding what economists think about where business cycles come from."

I don't think you are misunderstanding anything. One difference though: in most macroeconomic models there is a central bank that is supposed to be trying to stabilise the system in response to exogenous shocks plus endogenous dynamics. So those shocks and dynamics always have to be understood relative to the central bank's expectations and reactions. It is plausible that the central bank lacks foresight, and that there is a lag in the effect of its reactions, so that exogenous unexpected events are easy to imagine, while predictable endogenous cycles that cannot be offset by the central bank are less easy to imagine.

Nick:

So let me put my argument to you another way.

1) Can you think any observable macroeconomic behaviour (e.g. any particular set of moments, correlations, impulse-response functions) that cannot be justified by some model with "micro-foundations"? Put another way, is there anything at the macroeconomic level that microfoundations rule out?

2) Is there any observable behaviour macroeconomic behaviour that can only be justified by one "interesting" model with microfoundations? (I want to treat all models with only trivial differences as the same.)

If you're going to drop functional form restrictions on things like preferences and technology (and I'm having trouble thinking of a macro paper where I've seen that done), I'm not aware of any testable predictions of microfoundations (point 1) and I'm not aware that they (i.e. the set of admissable micro-founded models) have any policy implications (point 2). Which makes me wonder why some are so keen on them.

"There are other arguments for wanting microfoundations for policy advice. Not just the Lucas Critique, but the argument that if policy is supposed to be about people's well-being, it might be a good idea to have some people in the model, so we can see what happens to their well-being when policy changes."

Nick, you're a well-educated, articulate and smart guy. I'm sure you know about Arrow's Impossibility Theorem. Do you teach it to your graduate students in macro before you do welfare analysis? If so, I'd like to know how you keep them interested in what representative agent models have to say about social welfare.

Nick:

You're welcome for the links, thought you might like them.

Re: no ecological equivalent of the central bank, that's a very good point.

Also, via Felix Salmon, just saw this, which seems relevant to the dynamics and stability issues we've been touching on:

http://blogs.hbr.org/cs/2012/04/there_is_no_invisible_hand.html

Simon: the simple answer to your questions 1 and 2 is (of course) "no". But I could ask exactly the same questions, simply dropping the words "with microfoundations", and get the same answers "no". Any set of data is always compatible with more than one model, whether that model is microfounded or not. So, if they were taken as the last word, your questions would imply that all models are useless. We just look at the data, and stop there. But we don't do that. We try to fit patterns to the data. And we try to think of arguments why one pattern is more plausible than other patterns. We don't allow ourselves infinite degrees of freedom in pattern-fitting. We place restrictions on what patterns we try to fit. Microfoundations are one of those restrictions. And there's always a tension between fitting the data and restricting the number of degrees of freedom. That's life, for us poor souls.

Take the monopolistic competition example. When I eyeball the data, I get the sense that, starting in LR equilibrium, an increase in AD will cause Y to increase. If I try to build a model which does that, and assume perfect competition, I have to drop my normal assumption that Q=min{Qs,Qd} and replace it with Q=Qd, which is an assumption I find much less plausible. With monopolistic competition I can easily understand why, starting in full profit-maximising equilibrium, with sticky prices, an increase in demand would cause output to expand up to the point where MC=P.

I don't teach Arrow. I leave that to the micro people. But then a determined insistence on Arrow would rule out almost all policy recommendations (there's always someone who wants the world to end!). You can argue that good monetary policy improves the welfare of the representative agent, then if someone wants to argue that it might make distribution worse, you think about that too, and so on.

If we only accepted perfect models and ironclad policy recommendations,...some other idiot would start making even less perfect models and even less ironclad policy recommendations. We are going to believe something and we are going to do something.

"Not predicting its future path. Not advising policymakers. But simply understanding how it works. "

This 'understanding' seems to me to be of very limited utility if you can't forecast with it and you can't give anyone advice. Isn't that what "understanding" is for?

...And how would you know if your "understanding" is correct if you can't make forecasts? (A harsher way to ask this question: if you make forecasts that are no better than guessing, why would you think your understanding is correct?)

Simon: Off-Topic, but thinking back to my PPP post. My little "test" of PPP was a cross-section test (with a more or less random sample of one country). You test the Amano-van Norden equation on time series data for Canada. Would it make sense to think of a cross-country version of the test for the AvN equation? In other words, if I were running my same classroom experiment, only using AvN rather than PPP, and asking a few more questions in addition to the price of eggs, would that make sense? (Possibly not).

Darren: every single thing we all do is useless, if you are looking for some ultimate instrumental end.

There are unconditional forecasts about the future, and conditional forecasts, sometimes about the past and present, as well as the future. We can sometimes do the second, even if we can't do the first.

"Darren: every single thing we all do is useless, if you are looking for some ultimate instrumental end."

Nick, that's a very, very easy out. Too easy.

Let me put it to you this way: what value does your "understanding" of the economy generate, if you can neither make forecasts or offer policy advice? Who would pay you to "understand" the economy to the limited extent that you seem to be satisfied with?

If economics is nothing more than useless "art" then count me out. Poets and ballet dancers can't make forecasts or offer policy advice either, but their work is certainly a lot more pleasant/enriching to contemplate than the typical economics paper.

Wasn't it Keynes who said: "if economists could be thought of as humble, competent people like dentists, that would be splendid"? It seems like we're a long way from that.

"One difference though: in most macroeconomic models there is a central bank that is supposed to be trying to stabilise the system in response to exogenous shocks plus endogenous dynamics. So those shocks and dynamics always have to be understood relative to the central bank's expectations and reactions. It is plausible that the central bank lacks foresight, and that there is a lag in the effect of its reactions, so that exogenous unexpected events are easy to imagine, while predictable endogenous cycles that cannot be offset by the central bank are less easy to imagine."


Remember though, this only applies if a natural rate of interest exists. without a natural rate of interest that stabilizes the economy (in wicksell's original model, bringing savings into equality with investment), central bank adjustments of the money rate of interest won't necessarily have a stabilizing effect (in the wicksellian sense), no matter where it is set. In other words, the existence of a natural rate of interest is a major justification for not centering economics around endogenous instability.

Darren: my car is both useful and beautiful. I drive it to get to work, and enjoy driving it to work. Can't economics be both too? Now, chess; that's something that is totally useless, and a total waste of lots of brain power, IMHO. But some people still want to study it.

Nathan: I see your point (I think). But I don't think your conclusion *necessarily* follows. Here's a post I did with a toy model (not to be taken too seriously) that did not have a natural rate of interest. I don't think it's obvious that monetary policy would be useless in that model. If you see the monetary policy transmission mechanism as necessarily working through creating differences between the actual vs the natural rate, a la Wicksell, then you may not see it my way.

When I think about the sort of preferences I would need to assume to get *no* natural rate of interest, I have a hard time coming up with something vaguely plausible. Multiple natural rates, maybe (though not in the Sraffian sense of multiple natural rates, because I don't think that really is multiple natural rates, just different measures of the same natural rate.).

@Nick: I didn't mean to imply that interest rates don't influence the economy (ask any bondholder). my point was that it's not the stabilization catch all it is in Wicksellian and Neo-Wicksellian (incorrectly referred to as New Keynesian) models.

I'd ever so slightly suggest that modelling without a natural rate means abandoning equilibrium tools and jumping to dynamic math like differential equations (hence the discussion of predator prey models above).

Nathan: "I'd ever so slightly suggest that modelling without a natural rate means abandoning equilibrium tools and jumping to dynamic math like differential equations (hence the discussion of predator prey models above)."

Hmmm. I think that *even if* you model with a natural rate equilibrium you still need something like those differential equations. The natural rate will be a time-path rather than a constant number, and if you are off that path at one point (which you almost certainly will be unless the central bank has a crystal ball) that will change the future time-path. It's one of the main reasons I'm unhappy with the Neo-Wicksellian approach to monetary policy. Stability (in some sort of sense) can be a problem, and I think the whole ZLB thing is a symptom of that problem.

As an aside, why do you say "...Neo-Wicksellian (incorrectly referred to as New Keynesian)..."? I happen to agree with that (mostly, because some earlier New Keynesian models weren't Neo-Wicksellian). You have e.g. Woodford in mind, right?

"I'd ever so slightly suggest.."
It's OK. You are not at all like PP. ;-)

Nick (and others): you might find this interesting: http://www.guardian.co.uk/commentisfree/2012/apr/12/noel-edmonds-day-i-met-troll. About on-line comments, and how people can be unaware of how they come across on-line.

I agree that microfoundations are important and they do have macro implications. There is a huge micro problem out there that few economists, to my knowledge, have tried to grapple with. It concerns firm behaviour and it has major implications for savings rates, the nature of savings and for macro cycle stability, the rate of change of macro variables.

The problem is the nature of employment. It is in part a generational gap. People of Nick and Frances' age assume "Employment" to be full-time standard employment, ending at retirement. That isn't nature of all employment anymore. Today we have a significant amount of non-standard employment, contract or term-limited work and self-employment, all of which is precarious. So the precariousness of employment is no longer directly related to the precariousness of the firm, by design the employment is more precarious than the firm's profit expectations. Policies aimed at the firm to increase employment and income will not necessarily have the effect they did formerly because of the precarious nature of employment.

Precarious employment, shortening the expected time duration of employment has vast implication for the potential to be unemployed, the rate of household savings and the structure of retirement provision, if any. The classic assumption of defined-benefit pensions, which Nick and Frances repeatedly go to when making retirement analysis no longer holds.

This shortening of the duration of employment is matched by the decline of DB pensions which assume firms have longer time horizons than workers. Firms have reversed that assumption.

Economists have singularly failed to examine why firms want to shorten their horizons. I believe it relates to the decline in expected investment return and an increased belief in the likelihood of losses, in short an extended stagnation.

Here is a good quote on the subject by Stephen Roach, chairman of Morgan Stanley Asia:

America faces many tough problems in the early 21st century. But none seem as painfully intractable as those bearing down on US workers. A productivity paradox is at the heart of the problem. Despite a doubling of trend productivity growth over the past 15 years—with 2.7 per cent average annual gains since 1995, representing a stunning turnaround from the anemic 1.4 per cent pace over the 1973 to 1995 period—worker pay has continued to lag. Gains in inflation-adjusted compensation per hour (wages plus benefits) have averaged only 1.6 per cent since 1995—fully one percentage point less than productivity growth over the same time frame.

This outcome violates one of the most basic tenets of economics—that workers are eventually rewarded in accordance with their marginal productivity contribution. The Great Recession of 2008–09 has added insult to injury—pushing the official unemployment rate up to 10 per cent and more comprehensive measures of labour market slack into the high teens. Little wonder that American workers are feeling more disenfranchised today than at any point in the post-World War II era.

When I try to bring this up, I get dismissed. The wage as the marginal product of labour has been rebuked, empirically. That has major implications for savings rates, the cycle of funds from savings into investment and the sources of funds for investment. Why are firms behaving this way, do they they feel their horizon is precarious as well?

I believe this is a source of many macro problems but to handle those you have to deal with some uncomfortable micro truths.

@Nick: Yes Woodford, is especially who comes to mind when i say that (but Krugman does too). good point about time paths.

Thanks for the compliment about Philip. Sometimes I feel like he's the id of a Post-Keynesian.


@determinant: Actually, I think the point you're should drag things closer to the neoclassical vision of the labor market, rather then farther away. Remember the existence of a firm at all was problematic for the classic neoclassical model. hence the prominence George Stigler got for his transaction cost theory of the firm. If what you say is true (which i have some reservations), it would imply (at least to a mainstream economist) that transaction costs have fallen and we're getting closer to the basic Neoclassical vision of the economy.

Except the modern economy is generating large amounts of involuntary unemployment. I believe classical economics does not recognize or has extreme problems with the concept of involuntary unemployment.

@Determinant: Gosh I can't believe I'm doing this but, Neoclassical economics can explain involuntary unemployment. it can go the sticky prices route so market's don't clear or transaction cost explanations and so on. You are correct that the basic model can't deal with involuntary unemployment very well. The other explanations may or may not work well, but not because of involuntary unemployment in and of itself.

Can't believe what Nathan? I'm curious, I'm not trying to make a snarky political point.

I have an engineering degree and I find it hilarious that economists use the word "sticky". In Engineering we call it hysteresis, it means that the material has a storage property and that the result of the function is path-dependent.

It also means that any model using sticky prices is not linear, as a model with hysteresis is not linear since for each value of x there is more than one value of f(x). It's fine, we have plenty of ways to work around it but you have to acknowledge the new nature of model before you can deal with it.

But it seems to me that economists of all sorts can't get away from linear thinking even though their models aren't linear.

Nathan: As far as I remember you don't even need search costs, or sticky wages. All you need is market power in the *goods* market for a perfectly competitive labour market not to clear at any positive wage. I think the result requires fairly inelastic demand for goods beyond a price threshold (maybe declining revenues with output beyond a threshold - don't exactly remember). Anyways, it doesn't take very much of the kinds of inefficiency we see in the real world for wages to slip below the marginal product of labour.

@K: that's true too. my point was more that there are immense amount of ways to get involuntary unemployment

@ Determinant: Well normally I'm on your side and I think you make very good points, but i don't think your initial criticism in and of itself debunks mainstream economics. they have many ways of dodging it. For me, it's important to have a very accurate and detailed understanding of how mainstream economic models work because it makes criticism (and the critic) much more credible.

Determinant: Sticky doesn't *mean* path dependent. Yes you can refer them as a very particular category of single factor Markov path dependent positively autoregressive price processes. Or we could call them "sticky."

Nathan: "my point was more that there are immense amount of ways to get involuntary unemployment"

Yup! I was just agreeing with you by pointing out that you don't, in fact, even need a non-Walrasian labour market in order to get an inefficient one.

@Nathan Tankus:

I'm not trying to debunk mainstream economics, just point out their methods could use some improvement. I'm an incrementalist not a revolutionary.

@K:

http://en.wikipedia.org/wiki/Hysteresis

I believe that graph at top right describes sticky price as well as it does an electric field. All it needs is for the path to be dependent on the previous position as well as the present one.

@ Determinant: haha. some mornings i'm one and others i'm another.

It's just failure to acknowledge involuntary unemployment is something I can't stand.

Determinant: Ferroelectricity is a *particular* kind of hysteresis. That's why we have a special name for it. We don't just call it "hysteresis" because that's far too general. There are a variety of possible sticky price models, some of which may be similar to ferroelectricity. I haven't thought about it. But "ferroelectricity" would be a bad name for it. "Sticky" seems good.

Guys! I want to clear up one point on the relation between: involuntary unemployment; wage W; and value marginal product of labour VMP.

Lets define "involuntary unemployment" in the everyday sense of "I can't get a job but I would be more than willing to work at a wage that people just like me are earning".

In the simplest competitive labour market model, the height of the labour demand curve (at any point) is VMP. The height of the labour supply curve (at any point) is the Marginal Disutility of Labour MUL (more strictly, the Marginal Rate of Substitution between Leisure and consumption). With no involuntary unemployment, at equilibrium where the S and D curves cross, VMP=W=MUL.

Now lets assume that W is stuck above that equilibrium point, due to stickiness, monopoly power, minimum wage laws, an efficiency wage model, or whatever. Employment gets determined by the quantity of labour demanded at that wage. Quantity of labour demanded is less than quantity of labour supplied. The market is "on" the labour demand curve and "off the labour supply curve. There is involunatry unemployment in the sense defined above.

Here's the bit you are getting wrong: W is still equal to VMPL. What involuntary unemployment "means" is that W is greater than MUL.

"Involuntary unemployment" in the everyday sense means "I would strongly prefer the utility of a paypacket to the utility of leisure, but I can't do the swap". That says W greater than MUL. It says nothing about W and VMPL. The economy is off the labour supply curve. It says nothing about whether the economy is off the labour demand curve.

I hadn't noticed before, but yes; economists do use the words "sticky" and "hysterisis" in very idiosyncratic ways. But it works for us. There's a logic to it, even though it's not obvious.

Suppose wages and prices are perfectly flexible. The economy starts in equilibrium, then gets hit by an earthquake. It takes 10 years for the economy to get back to where it was. We do not use the word "hysterisis" there.

Suppose wages and prices are sticky. The economy starts in equilibrium, then gets hit by an AD shock. It takes 1 year for wages and prices to adjust and become perfectly flexible, but it takes 10 years for the economy to get back to where it was. The effects in year 1 are due to sticky wages and prices. The effects in years 2 to 10 are due to hysterisis.

Weird, huh?

K: "Determinant: Ferroelectricity is a *particular* kind of hysteresis. That's why we have a special name for it. We don't just call it "hysteresis" because that's far too general. There are a variety of possible sticky price models, some of which may be similar to ferroelectricity. I haven't thought about it. But "ferroelectricity" would be a bad name for it. "Sticky" seems good."

Aha! For us, "stickiness" is a very particular kind of slowness to adjust to shocks. And "hysterisis" is a slowness to adjust to a very particular kind of shock due to stickiness.

Only prices (and wages etc) can be "sticky". And "hysterisis" means slowness to adjust to the consequences of sticky prices+shock even after the stickiness of prices has gone away.

Nick: Sorry for the slow responses....been working.

"...your questions would imply that all models are useless. We just look at the data, and stop there. But we don't do that. We try to fit patterns to the data. ... We place restrictions on what patterns we try to fit. Microfoundations are one of those restrictions. "

So, you agreed that microfoundations place no real restrictions on the data or the patterns that we see....and then argue that microfoundations are useful restrictions. Obviously, I'm confused....but even more broadly, if you think that (1) we need restrictions, and (2) the micro approach gives us some interesting ones, I don't think your argument is done. I thought you were arguing that microfoundations give *essential* restrictions -- that any approach without it is inferior. (Perhaps I'm reading too much into what you wrote...but what I'm describing is certaintly a popular view in macro.) Your logic seems to fall well short of that. What am I missing?

I don't teach Arrow. I leave that to the micro people. But then a determined insistence on Arrow would rule out almost all policy recommendations (there's always someone who wants the world to end!). You can argue that good monetary policy improves the welfare of the representative agent, then if someone wants to argue that it might make distribution worse, you think about that too, and so on.

"If we only accepted perfect models and ironclad policy recommendations,...some other idiot would start making even less perfect models and even less ironclad policy recommendations. We are going to believe something and we are going to do something."

There's an old episode of Yes, Minister/Yes, Prime Minister where someone's logic is reduced to
1) We must do something.
2) This is something.
3) Therefore, we must do this.
Your argument reminds me of that. There's many arbitrary ways to generate policy recommendations; microfoundations are one of those ways. But this does not explain why we have to foresake all other illogical or unreliable methods for this one.

(And don't get me started on why we are keen to generate policy advice from models that we admit may easily be giving the wrong advice.)

Sorry....shouldn't have included that paragraph about Arrow in the above (that was from your earlier post.)

Simon: "What am I missing?"

Nuance. ;-) The word between yes and no. The idea that (nearly) all evidence, arguments, and restrictions, are tentative and provisional, rather than watertight. Other things equal, a model that also makes sense at the micro level is more credible than one that doesn't, or one that we don't know whether it makes sense at the micro level or not. We are trying to fit a Quinean web of belief onto a lot of "facts" that we don't even know are facts. Other things equal, the wider that net, the better we can believe it makes sense of the world.

Let me put it this way instead. The wider the data set that is encompassed by the model, the better the model, other things equal. A model that explains both X and Y is better than a model that explains X and says nothing about Y. Why should we draw a line between macro Y and micro Y?

Yes, I'm not as hardline as those who say that only microfounded macro models should be accepted. We should never be satisfied with a non-microfounded model, but we can't always get what we want.

Nick,

I found the paper that describes the labour equilibrium I was thinking about when I wrote the above comment. Take two monopolistic producers of two imperfectly substitutable goods, diminishing revenues from output above a threshold, a Walrasian labour market, and workers with *zero*  disutility of labour; incredibly you can still get unemployment at *any* positive wage, and the rest of the workforce employed *below* the VMPL, a nasty GE result indeed. Is it realistic? It doesn't seem absurd to me that we have strongly declining marginal utility for the current consumption basket. Maybe we are short on stuff we want to buy more of. This is obviously the important assumption as it makes it pretty easy to imagine that the profit optimizing output might involve a limited quantity of labour.

Are the assumptions otherwise inconsistent with real world data, such as income distributions? I haven't thought about it enough - the paper doesn't address the details of how Say's law ends up balanced. So perhaps it implies some particular unrealistic implications for distribution of capital ownership and government redistribution. Worth thinking about though.

On hysteresis:

"Hysteresis" just means memory. The state of the system depends not just on exogenous variables, but on previous values of the state variables. Of course, any system with continuously changing state variables (e.g. mechanical inertia) could be described as falling in this category, so the name is usually used when there are closely related systems that don't exhibit this property in the same variable (paramagnets have it, diamagnets don't). Prices that can't just change to the Walrasian equilibrium in response to whatever exogenous changes in supply/demand are definitely an example of hysteresis in the price variable. The previous level of the price is an important state variable in the system. My only point was that "hysteresis" is far too general a concept to use as a *name* for "sticky price processes." Solid state physics is full of examples of materials with "hysteresis". Many of them are special in some particular way, so physicists give them special names. Economists should do the same, and, of course, they do.

Thanks K. I have skimmed it. I am annoyed they didn't reference my 1987 paper which showed exactly the same thing, in a fully macro model! Instead they reference Weitzmann 1982, which is wrong because he forgets to include profits in the budget constraint! Ah well.

Here's the jist. If we replace perfect competition with imperfect, the height of the labour demand curve becomes Marginal Revenue Product rather than Value Marginal Product.

VMPL=P.MPL

MRP=MR.MPL= (1-(1/e)).P.MPL where e is elasticity of demand and MR is Marginal Revenue.

So, with imperfect competition, W will be less than VMP.

Imperfect competition (generally) makes the demand (curve) for labour lower than it otherwise would be, and equilibrium wages and employment lower than they otherwise would be. It doesn't really get you involuntary unemployment, contrary to the assertion in that paper (OK, I didn't actually read it). In their example (like in my 1987 model) it does push equilibrium wages down to zero. But that's only because they (and I) assumed a very clunky reverse-L-shaped labour supply curve. With W=O, nobody who is not working prefers working. That's not like real world involuntary unemployment, where some people are working at W, and others (just like them) want to work at W and can't get a job.

Even more annoying, IIRC, the QJE turned down my paper, even though it was better than that one, and earlier!!

Nick,

"I am annoyed they didn't reference my 1987 paper which showed exactly the same thing"

Sorry for mentioning it...

"[Weitzmann] forgets to include profits in the budget constraint"

...that guy's such a dufus...

"the QJE turned down my paper"

...son of a #%*@$!!! :-)

" the height of the labour demand curve becomes Marginal Revenue Product rather than Value Marginal Product."

That makes sense. Thanks. Do you have a link to your paper? I'd love to read it.

"that's only because they (and I) assumed a very clunky reverse-L-shaped labour supply curve"

That labour supply curve may not be *that* crazy. If we assume that those people earning that low equilibrium wage own little capital (and need a roof and some food), the labour supply curve could be downward sloping at the bottom. Vertical might be a conservative assumption. Some kind of indentured servitude equilibrium? Foxconn?

@Nick: you're right. i didn't talk about marginal productivity theory, only ways of getting involuntary unemployment

I think I've just come to understand consumer debt as a way to make labour supply curves slope downwards. Debt is like food or housing, but unlike basic goods it ratchets upwards to whatever your wage level might be. Then, when negative wage/income shocks hit you *must* work more in order to service the debt. I'm sure this was obvious to lots of people, but seeing it as a negatively sloped labour supply is new to me. Humans are such a bunch of suckers!

K: thanks, but my old paper was quite good 25 years ago, but not now. My post here says the same thing more cleanly. Just pretend the MC curves are labour supply curves, the demand curves are VMP curves, the MR curves are MRP curves, replace Y with L, Pi/P with W/P, and you have the model.

"Other things equal, a model that also makes sense at the micro level is more credible than one that doesn't, or one that we don't know whether it makes sense at the micro level or not." Let's leave aside arguments about "credibility." The point made by many outside of macroeconomics is that what macroeconomists call "micro-foundations" are not, in fact, supported by microeconomics. Microeconomists do not assume that social welfare can be judged by the welfare of one individual ("representative" or not.) Microeconomists do not think that aggregate levels of production, in a world with diminishing marginal returns to factors, will be independent of how those factors are distributed. Macroeconomists who start to look at micro data (e.g. on labour flows of individuals or firm-level productivity) often find that much of what matters at the aggregate level is not well-captured in a representative agent framework. So I'd agree that models with good micro-foundations are more credible.....I just don't see macroeconomists use or teach them.

"Let me put it this way instead. The wider the data set that is encompassed by the model, the better the model, other things equal." It almost sounds like you're saying that the best model is one that can never be empirically falsified, but I don't think that's what you have in mind.

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